For decades, three large credit rating agencies have together sat in judgment over the financial soundness of governments, multilateral organisations and, crucially, companies that borrow in the international capital markets to fund their activities.
The pronouncements of these high priests of finance, along with a few smaller rivals, affect the cost of funds for issuers of debt, and are often enshrined in the regulations that govern what securities can be bought by insurance companies, pension plans and mutual funds. Ratings can single-handedly create or render obsolete particular kinds of securities. A downgrade can even tip countries towards recession or companies towards bankruptcy.
But are the big three – Standard & Poor’s, Moody’s Investors Service and Fitch Ratings – up to the job, particularly in the huge, fast-growing and complex market for “structured finance”?
In this world, mortgages, car loans, corporate bonds and many other types of debt are packaged and repackaged by investment banks and sold on to all sorts of investors, from pension funds and insurance groups to hedge funds and bank trading desks. The key to a successful deal is securing the right credit rating.
How these ratings are decided upon is the subject of growing anxiety, with concerns hinging on the relationships between the agencies and big investment banks on Wall Street and in the City of London. Some worry about the potential for conflicts of interest, given that investment banks rather than investors pay for ratings. Others simply think the agencies can be confused by the complexity of the deals they are asked to rate, and are not equipped to keep up with the creativity and resources of the banking world.
“The credit rating agencies have got a little more sophisticated but they are way behind the investment banks,” says Frank Partnoy, a professor at the University of San Diego’s School of Law and a former Wall Street banker.
Moreover, with structured finance deals now created using derivative instruments as well as bonds and loans, some investors who cannot keep up with the complexity are relying on the rating agencies’ opinions more heavily than ever before.
“Insurance companies are much more dependent on ratings, as are people like us,” says Sabur Moini, head of credit strategy at fund manager Payden & Rygel. “The non-traditional buyers [such as hedge funds] are a lot less ratings-reliant.”
Confidence in the ratings agencies to get it right has been shaken recently by a number of missteps and controversies. Moody’s and S&P, for example, have had to downgrade dozens of newly-issued securities backed by US subprime home loans as late mortgage payments and defaults by borrowers have spiked more severely than the agencies initially expected – suggesting the assumptions underlying the ratings might have been flawed.
Meanwhile, in an unusually public spat, Fitch and another smaller agency have questioned Moody’s and S&P’s rating methodologies for the first of a new breed of highly structured and potentially volatile derivative products called constant proportion debt obligations (see right).
Moody’s was also forced into an embarrassing U-turn in March when a new method of rating banks – taking into account the likelihood of government bail-outs – met with ridicule from analysts and investors.
In the rarefied air of structured finance, coming up with a rating is fraught with challenges. A typical mortgage-backed securities deal, for example, involves repackaging thousands of mortgages – worth hundreds of millions of dollars altogether – with each borrower having a different credit history.
An investment bank undertaking such a deal issues batches of new securities backed by this portfolio. Investors who buy the riskiest of these are the first to suffer from losses if any of the borrowers default. These bonds may get no rating at all. Investors who buy the least risky securities do not lose anything until all the other investors are wiped out, meaning that these securities, often three-quarters or more of the total deal, usually carry triple-A ratings.
Rating such instruments requires complex analysis and sophisticated computer modelling, making the task a daunting one. As a result, many investors say, ratings in structured finance are hard to corroborate independently. Some also complain that it is hard for them to reach the agencies’ inner sanctum and speak directly to analysts.
Yet with almost $9,000bn (£4,500bn, €6,600bn) of structured securities outstanding in the US alone – more than double the size of the US government bond market – the agencies now make the bulk of their profits from rating such products.
Moody’s, for example, made 44 per cent of its revenue last year from structured finance deals. Such assessments also command more than double the fee rates of simpler corporate ratings, helping keep Moody’s operating margins above 50 per cent.
The potential for conflicts of interest in the agencies’ “issuer pays” model has drawn fire before, but the scale of their dependence on investment banks for structured finance business gives them a significant incentive to look kindly on the products they are rating, critics say.
One regulator taking the fight to the rating agencies is Michel Prada. From his office in Paris, the head of the Autorité des Marchés Financiers, the main French financial regulator, is raising fresh questions over their role and objectivity.
Mr Prada sees the possibility for conflicts of interest similar to those that emerged in the audit profession when it drifted into consulting. Here, the integrity of the auditing work was threatened by the demands of winning and retaining clients in the more lucrative consultancy business, a conflict that ultimately helped bring down accountants Arthur Andersen in the wake of Enron’s collapse. “I do hope that it does not take another Enron for everyone to look at the issue of rating agencies,” he says.
Mr Prada is not the only official with at least private misgivings about structured finance ratings. The Bank for International Settlements, the Basel-based “bank for central banks”, has also studied structured products and is understood to be alarmed by the speed with which they have sometimes been downgraded in the past.
Larry White, an economics professor at New York University’s Stern business school, also cites the example of Arthur Andersen. In general, he says, the rating agencies’ standard contention that its reputation for objectivity is too important to be jeopardised by conflicts of interest is a reasonable one.
“But that’s what Arthur Andersen told us as well,” he says. “You have to keep those words ‘Arthur Andersen’ in your mind.” Prof White thinks that on balance, however, the big agencies have “a pretty good track record”.
The rating agencies themselves emphasise that preserving the credibility of their ratings is crucial to their success. In structured finance, as elsewhere, they say they manage their businesses carefully to avoid conflicts and to maintain objectivity.
Gloria Aviotti, head of global structured finance at Fitch Ratings, points to evidence that structured finance ratings are statistically comparable with, and at least as stable as, corporate ratings.
She also says rating methods for structured products – a class that includes mortgage-backed securities and collateralised debt obligations, or CDOs – are among the agency’s most clearly and publicly defined. That transparency, she argues, helps avoid conflicts because it gives investors the opportunity to see that Fitch treats all similar structures in the same way.
Noel Kirnon, a senior managing director at Moody’s, adds that “investors have the ability to challenge our work constantly”. He says there are plenty of tools available to help investors evaluate independently the securities they are offered.
Beyond the scope for conflicts of interest, however, there are also concerns that the rating agencies are simply out of their depth. With new deals piling up daily, people such as Mr Moini at Payden & Rygel need to be confident that the agencies can cope. But he worries that they struggle to retain experienced staff.
Richard Stein, head of the capital markets practice at recruitment firm Korn Ferry, says that structured finance rating experts are very valuable to investment banks. “It’s not unusual for banks to offer analysts compensation packages that are three or four times what they’re earning at the rating agency,” he says.
Prof Partnoy concurs: “Wall Street rarely finds someone smart at credit rating agencies, but when they do they hire them.” He says that this brain drain makes it difficult for agencies to keep up with changes in the market.
Partly because of such challenges, Mr Prada at the AMF worries that structured finance ratings might be more vulnerable to rapid downgrades than ratings for more traditional debt such as corporate or government bonds, something that could lead to a dramatic fall in the value of an investor’s assets.
Rating agencies dispute the concern, claiming that the ratings in structured finance are no more volatile than those in simple bonds, based on an analysis of historical data.
But Dan Fuss, vice-chairman and bond fund manager at Loomis Sayles, shares some of Mr Prada’s fears. In structured finance, he says, investors are more exposed to low probability but dramatic events that “knock the liquidity out from under a market”.
In other words, he thinks structured instruments are potentially more vulnerable than traditional corporate debt to a rush of selling by investors in the event of a downgrade. “[The prices of the two types of instrument] would behave in different ways, even with the same rating,” he says.
The agencies highlight that their ratings explicitly do not address market pricing or trading liquidity for the security in question, but rather focus on the likelihood of default. However, some investors may not appreciate that distinction and could be surprised by volatile prices. Mr Fuss also notes that many newer structured instruments have not been through a serious, broad-based market downturn, making their behaviour hard to predict.
The benign borrowing conditions of recent years have been punctuated by a series of events that has rattled, but not derailed, markets. In spite of the ongoing turmoil in markets with exposure to US subprime mortgages, those smooth conditions appear to be continuing for now.
Yet most investors and analysts believe a change in credit conditions is coming and could be severe. Rating agencies are already under fire in the subprime mortgage world, although the final extent of defaults and downgrades is not yet known.
When the tide does turn and a broader range of companies and structured deals are downgraded, the agencies are likely to feel more heat for their apparent lack of prescience. “I think our ratings are going to look good, but we are still going to be criticised,” says Ray McDaniel, chief executive of Moody’s.
Officials at some of the big agencies are already looking for ways to head off any regulatory action – particularly in Europe where, as one such official puts it, “bureaucrats have a long history of meddling if things go wrong”.
It is far from clear whether US or European officials have the appetite to ramp up their monitoring of the agencies beyond the current light supervision, which is in the process of being revamped in the US. They have previously backed away from such moves.
Whether regulators do act may depend on the severity of what happens next in the structured finance market. Many observers share the outlook of Sylvain Raynes, a former Moody’s analyst who is now a partner at advisory firm R&R Consulting.
“Some big thing – negative – is going to happen. They will all blame someone. The names they will see will be Fitch, Moody’s and S&P.”
How S&P put the triple A into CPDO
Last summer a team of financial whizzkids at ABN Amro, the investment bank, developed a new debt product that has since taken the markets by storm. Using complex mathematics, the designers had wanted to create an instrument that would pay the same high interest rate as a “junk” bond but be as free from risk as a bank deposit, writes Paul J. Davies.
The new credit product was not a bond, nor a stock, nor anything anyone had seen before. A fantastically complex instrument that used a mathematical strategy to make a highly leveraged bet on a pool of credit derivatives, it was given the ungainly title of a constant proportion debt obligation, or CPDO.
It pays an interest rate two percentage points above returns on government bonds, similar to a risky junk bond, but it is supposed to be virtually risk-free, possessing a triple-A rating against default.
The only controversy is exactly how it got such a rating. Before releasing it, ABN Amro held months of discussions with Standard & Poor’s, the credit rating agency, about how the new instrument might work and what rating it could earn.
ABN Amro wanted a triple-A, the highest there is, which it saw as critical for the marketing of the CPDOs. Securing such a rating meant the investment bank could sell the instruments to a wide pool of investors, including pension funds and others that are often barred from holding assets with lower credit ratings.
S&P eventually reached the conclusion that the chance of default on a CPDO was very low indeed. The decision shone a light on the close interaction between the agencies and investment banks, which is now triggering questions from regulators and investors.
The agency was also paid handsomely for its work. Although the precise figure is confidential, rating ABN Amro’s CPDO deal, worth €1.35bn ($1.8bn, £900m), could have paid anywhere from €500,000 to €1.62m or even higher, according to typical pricing models.
Moody’s, the rival agency, later also awarded top ratings to similar deals. But some observers were surprised by the high ratings and thought the agencies had been duped. “Credit rating agencies are not well qualified to assess the market risk combined with leverage presented by these products,” says Janet Tavakoli, an independent consultant on structured finance.
Fitch Ratings and DBRS, two rival agencies, said last month that such first-generation CPDO deals deserved a single-A rating at best. After taking a step back to reassess their models, both Moody’s and S&P have pronounced themselves comfortable with the triple-As and have not downgraded any deals – though some bankers whisper that similar instruments would never get the same ratings now.
“These are new and extremely complex products, therefore it is no surprise that regulators feel concerned,” says Ian Bell, head of European structured finance at S&P. “But the market has always known that the business model of rating agencies is to be paid by the issuers. In that way structured finance is no different from corporate bonds.”
He adds: “Banks come to us with a proposed transaction and we explain how it might be rated under our criteria. In many cases, the transaction is then restructured by the bank in order to meet our criteria. There’s nothing sinister about this process – we don’t advise on how deals should be structured or arbitrate on which deals can proceed or not.”
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